“I don’t see the flat yield curve or inverted yield curve as being the deciding factor in terms of where we should go with policy,” Williams said following a speech in Buffalo on Sept. 6.

Next up was Fed Gov. Lael Brainard. She broke new ground in a speech last week when she said she expects the short-run neutral rate of interest — the unobservable interest rate that keeps the economy growing at its potential — to rise above the Fed’s projected long-run equilibrium rate of about 3% as a result of fiscal stimulus.

Then she invoked the four most dangerous words in finance — “this time is different” — and applied them to the prospect of an inverted yield curve.

The spread between the 10-year Treasury note and the federal funds rate is still positive, but further rate hikes by the Fed could push the fed funds rate higher than the 10-year yield, inverting the yield curve and signaling a recession.

While “attentive to the historical observation” that inversions of the term structure of interest rates had a reliable track record of preceding recessions in the U.S., Brainard implied that this time is different because: 1) long-term rates are much lower now than they were during previous economic expansions; and 2) the term premium is very low. (The term premium is the extra compensation investors demand for holding a long-term Treasury security such as a 10-year note
TMUBMUSD10Y, +0.19%
instead of one that matures in months.)

The significance of an inverted yield curve was even a topic of discussion at the Fed’s July 31-Aug. 1 meeting. “Several participants” advised paying attention to the curve in assessing the economic and policy outlook. “Other participants” said it was inappropriate to infer “causality from statistical correlations.”

Forget statistical correlations. What’s important is the intuition behind the yield curve: What it says, and why it works.

The juxtaposition of an artificially pegged short-term rate and a market-determined long-term rate is a succinct expression of the stance of monetary policy. (For simplicity’s sake, I will ignore interest on excess reserves, which the Fed also sets, and focus on the Fed’s old-fashioned system of reserve management.)

The overnight interbank lending rate is set by the Fed, which adjusts the supply of reserves to meet the banking system’s demand.

(Banks are required to hold reserves as vault cash or as deposits at a Fed bank on demand deposits and checking accounts.) If the Fed supplies fewer/more reserves than the banking system demands, the funds rate will rise/fall.

Imagine a situation where the economy is strong, market rates are rising across the curve and the fed funds rate is steady. It’s fair to assume that increased demand for credit would be pushing up the overnight rate as well were it not for the Fed’s largesse. In other words, a steeper curve equates with an expansionary monetary policy.

Similarly, if the Fed is raising the funds rate — restricting the supply of credit — and market rates begin to decline, eventually breaching the overnight rate, one can be pretty sure that the Fed is running a restrictive monetary policy. Recession is the result.

These two interest rates encapsulate the stance of monetary policy. As an indicator, it’s about as simple as it gets. It’s available 24/7 to anyone who is interested and is never revised.

The term spread was pretty much ignored in previous business cycles. Now, it’s the talk of the town, in all its permutations.

Any two market rates — 2s/10s, 5s/30s — are game even though those spreads lack the intellectual rigor of the fed funds/10-year spread or, using a proxy for the overnight rate, the 3-month/10-year spread, which Bauer and Mertens say works best.

Many of the Fed district bank presidents — including St. Louis’s James Bullard, Atlanta’s Raphael Bostic, Dallas’ Robert Kaplan, Philadelphia’s Patrick Harker and Minneapolis’ Neel Kashkari — have expressed confidence in the predictive power of the yield curve. In recent months, all of them have said they want to avoid precipitating an inversion of the curve.

We have yet to hear anything definitive from Fed Chairman Jay Powell on whether he would view an inverted curve as a form of “forward guidance” in setting policy. We know he’s not married to the model, an least an econometric one.

In his speech at Jackson Hole last month, he said that setting monetary policy based on unknowable and ever-changing metrics — the natural rate of unemployment, the neutral rate of interest — is challenging. Short of any break-out of inflation expectations or unforeseen crisis, gradualism remains Powell’s preferred approach.

What we have yet to learn is whether Fed gradualism will be aborted if and when it runs into resistance from long-term rates.

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